The Comparable Profits and Cost-Based Provisions

The cost based provisions sit inside the methods set of Chapter 2 of the OECD Guidelines (2.62-2.80) and cover the routes where the arm’s length result is derived from a cost base plus a mark-up: the standard cost plus method and the comparable profits approach for routine transactions. Where the tested party is a manufacturer or a service provider that performs routine functions on a specified cost base, the arm’s length result is the cost base plus a comparable mark-up. The method is the natural home of contract manufacturing and routine service pricing, and its whole practical content is the definition of the cost base, the choice of the comparable mark-up and the comparability of the tested party to its comparables.

The provisions at a glance

Subject	What it covers
The cost based principle	The arm’s length price is the tested party’s cost base plus a comparable mark-up, where the tested party performs routine functions on a specified cost base
The cost base	The definition of the cost to which the mark-up is applied — the operating cost, the inventory cost or the specific cost base appropriate to the function
The comparable mark-up	The mark-up on cost that independent enterprises performing the same function achieve — the PLI for the method
The comparable profits approach	The cost-based result extended to routine transactions that do not fit the plain cost plus template — a mark-up on a specific cost pool
Contract manufacturing	The application to the contract manufacturer, which performs a specified manufacturing function for a mark-up on cost and bears little or no market risk
Routine services	The application to the routine service provider, which performs a specified service function for a cost-based fee
Comparability and adjustments	The comparability of the tested party to its comparables under the five factors in Chapter 3, and the adjustments for measured, reliable differences before the mark-up is applied

The cost base: the first decision

In paraphrase, the provision that defines which cost the mark-up is applied to — the operating cost, the inventory cost, or the cost base matched to the function — is cited whenever the base is in dispute, because the mark-up rate is only meaningful once the base is fixed. The design choices:

Cost base	Used when
Operating cost (excl. cost of goods)	The tested party’s value is in the process, not the inputs — many service functions
Inventory / direct cost	The tested party is a contract manufacturer processing materials into a product
Specific cost pool	The function is a defined activity — a shared-services pool, a toll-manufacturing run — priced on its own cost

A mark-up on the wrong base is the most common cost-based error: the rate may be perfectly comparable and the result still wrong, because the denominator does not match the function.

The comparable mark-up

In paraphrase, the mark-up must be the one independent enterprises performing the same function achieve. It is the cost-based leg of the PLI reference, and it ties back to the tested-party selection at 2.48 in Chapter 2: the mark-up reflects the tested party’s function, and a function that is not routine is not what the mark-up prices.

Contract manufacturing and routine services

• The contract manufacturer. The provision that the contract manufacturer, performing a specified function for a mark-up and bearing little market risk, is the canonical cost-based tested party is cited for every contract-manufacturing transfer. The manufacturer processes, assembles or packages to the principal’s specifications; the mark-up on the processing cost is the routine return.
• The routine service provider. The provision that the routine service provider performs a specified service function for a cost-based fee is cited for the shared-services and back-office chains. Where the services are low-value-adding, the services provisions carry their own safe-harbour logic.
• The comparable profits extension. Where the routine transaction does not fit the plain cost plus template — a specific cost pool, a mixed function — the comparable profits route applies the same principle: a mark-up on the specific cost base, measured against the independents that perform the same specific function.

What it means in practice

The cost based route is the default for routine Indian manufacturers and service providers, and the two disputes that recur are the base and the comparables. The base is settled by the function (what does the tested party actually do, and what is its cost of doing it?); the comparables are settled by the five factors and the adjust-versus-exclude rule. The working-capital adjustment is the standard fix for a measured difference in the base, applied before the mark-up.

Where this takes you

• The CPM in practice: the cost plus method guide.
• The CPM working guide: the CPM guide.
• The mark-up this chapter applies: the PLI reference.
• The tested party it benchmarks: tested party selection.
• The adjustment it makes before the mark-up: working-capital adjustment.